Monday, August 31, 2015

Many commentators have ably explained the double-bind the central banks of the world find themselves in.Doing more of what's failed is, well, failing to generate the desired results, but doing nothing also presents risks.

China's double-bind is especially instructive. While there an abundance of complexity in China's financial system and economy, we can boil down China's doomed if you do, doomed if you don't double-bind to this simple dilemma:

If China raises interest rates to support the RMB ( a.k.a. yuan) and stem the flood tide of capital leaving China, then China's exports lose ground to competing nations with weaker currencies.

This is the downside of maintaining a peg to the U.S. dollar. The peg provides valuable stability and more or less guarantees competitive exports to the U.S., but it ties the yuan to the soaring dollar, which has made the yuan stronger simply as a consequence of the peg.

But if China pushes interest rates down and floods its economy with cheap credit, the tide of capital exiting China increases, as everyone attempts to escape the loss of purchasing power as the yuan is devalued.

This is the double-bind China finds itself in: weakening the yuan to shore up exports incentivizes capital flow out of China, forcing the central bank to torch reserves to mediate the flood tide of capital fleeing China.

But efforts to support the yuan crush exports based on a cheap currency, creating the potential for mass layoffs in sectors with razor-thin margins and convoluted black box financing. Nobody knows how many times the stuff in warehouses has been pledged as collateral, or how much debt is floating around the shadow banking system in China.

Doomed if you do, doomed if you don't: trash your currency and watch capital gush out of your economy and financial sector, or support your currency and watch your export sector's sales and profitability crater.

Whichever option China chooses, it loses. Doing nothing doesn't work, either, as the central planners' incompetence and cluelessness is now on display. The flood of money leaving China will pick up speed due to uncertainty and fear of central planning desperation, and attempts to support the yuan are the equivalent of a chemical fire burning down the export sector.

Life is tricky that way.

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This is entirely predictable. Every fast-growing economy starting with near-zero debt and huge untapped reserves of cheap labor experiences an explosive rise as the low-hanging fruit is plucked and the same abrupt stall and stagnation when the low-hanging fruit has all been harvested, leaving only the unavoidable results of debt-fueled speculation: an enormous overhang of bad debt, malinvestment (a.k.a. bridges to nowhere and ghost cities) and policies that seemed brilliant in the good old days that are now yielding negative returns.

The Emerging Market Story Is Also Done

Emerging currencies and markets have soared on the back of the China Story, as China’s insatiable demand for oil, iron ore, copper, soy beans, etc. drove global demand to unparalleled heights.

This demand pushed prices higher, which then pushed production (supply) higher, as the low cost of capital globally enabled marginal resources to be put into production with borrowed money.

Now that China’s demand has fallen off—by some accounts, China’s GDP is actually in negative territory, despite official claims that it’s still growing at 7% annually—commodity prices have crashed, taking the emerging markets’ stock and currency markets down. (Source)

Here is a chart of Doctor Copper, a bellwether for industrial and construction demand:

Here is Brazil’s stock market, which has declined 54% in the past 12 months:

These are catastrophic declines, and with China’s growth story over, there is absolutely nothing on the global horizon to push demand back up.

Diminishing Returns on Additional Debt

The simple truth is that expanding debt has fueled global growth. Though people identify China as the driver of global demand for commodities, China’s growth is debt-driven. As noted above, China quadrupled its officially tracked debt from $7 trillion in 2007 to $28 trillion as of mid-2014—an astonishing 282 percent of gross domestic product (GDP). If we add the estimated $5 trillion of shadow-banking system debt and another year’s expansion of borrowing, China’s total debt of $35+ trillion is in excess of 300% of GDP—levels associated with doomed to default states such as Greece and Spain.

While China has moved to open the debt spigot in recent days by lowering interest rates and reserve requirements, this doesn’t make over-indebted borrowers good credit risks or more empty high-rises productive investments.

Borrowed money that poured into ramping up production in emerging nations is now stranded as prices have plummeted, rendering marginal production intensely unprofitable.

In sum: greatly expanding debt boosted growth virtually everywhere after the Global Financial Meltdown of 2008-2009. That fix is a one-off: not even China can quadruple its $35+ trillion debt to $140 trillion to reignite growth.

Here is a sobering chart of global debt growth:

Limits on Deficit-Spending (Borrowed) Fiscal Stimulus

When the global economy rolled over into recession in 2008, governments borrowed money by selling sovereign bonds to fund increased state spending. In the U.S., federal borrowing soared to over $1 trillion per year as the government sought to replace declining private spending with public spending.

Governments around the world have continued to run large deficits, piling up immense debts since 2008. The global move to near-zero yields has enabled governments to support these monumental debt loads, but even at near-zero yields, the interest payments are non-trivial. These enormous sovereign debts place some limits on how much governments can borrow in the next global recession—a slowdown many think has already started.

Here is a chart of U.S. sovereign debt, which has almost doubled since 2008:

As noted on the chart: what structural inadequacies or problems did governments fix by borrowing gargantuan sums to fund state spending? The basic answer is: none. All the same structural problems facing governments in 2008 remain untouched in 2015. These include: over-indebtedness, bad debts that haven’t been written down, insolvent banks, soaring social spending as the worker-retiree ratio slips below 2-to-1, externalized environmental damage that has yet to be remediated, and so on.

Central Bank Stimulus (Quantitative Easing) as Social Policy Has Been Discredited

In the wake of the Global Financial Meltdown of 2008-2009, central banks launched monetary stimulus programs aimed at pumping money into the economy via bank lending. The stated goals of these stimulus programs were 1) boost employment (i.e. lower unemployment) and 2) generate enough inflation to stave off deflation, which is generally viewed as the cause of financial depressions.

While it can be argued that these unprecedented monetary stimulus programs achieved modest successes in terms of lowering unemployment and pushing inflation above the zero line, they also widened wealth and income inequality.

Even as these programs made modest dents in unemployment and deflation, they pushed asset valuations to the moon—assets largely owned by the few at the top of the wealth pyramid.

Here is a chart of selected developed economies’ income/wealth skew:

The widespread recognition that the benefits of central bank stimulus mostly flowed to the top of the pyramid places political limits on future central bank stimulus programs.

The 2008-09 Fixes Are No Longer Available

In summary, the fixes for the 2008-09 recession are no longer available in the same scale or effectiveness. Expanding debt to push up demand and investment, rising state deficit spending, massive monetary stimulus programs—all of these now face limitations. This means the central banks and states have very limited tools to reignite growth as global recession trims borrowing, investment, hiring, sales and profits.

I personally don’t think the world has experienced a period in which capital preservation has become more important than capital appreciation since the last few months of 2008 and the first few months of 2009. Other than these five months, the focus has been on speculating to obtain the highest possible yield/appreciation.

This suggests to me that the next period of risk-off capital preservation will last a lot longer than five months, and perhaps deepen as time rewards those who adopted risk-off strategies early on.

Sunday, August 30, 2015

In markets distorted by permanent manipulation the most powerful incentive is to borrow as much money as you can and leverage it as much as you can to maximize your gains in risk-on asset bubbles.

A core dynamic is laying waste to global financial markets: the greater the level of central bank/government manipulation, the greater the systemic fragility.

One key characteristic of this fragility is that it invisibly accumulates beneath the surface stability until some minor disturbance cracks the thinning layer of apparent stability. At that point, the system destabilizes, as it has been hollowed out by ceaseless manipulation, a.k.a. intervention.

There are a number of moving parts to this dynamic of steadily increasing fragility.

One is that any system quickly habituates to the manipulation, that is, the system soon adds the manipulation to its essential inputs.

For example: if you lower interest rates to near-zero, the system soon needs near-zero interest rates to remain stable. Raising rates even a mere percentage point threatens to fatally disrupt the entire system.

Another is that permanent intervention (i.e. manipulation, or to use a less threatening word, management) strips the system of resilience. When participants are rescued from risk by central bank/central state authorities, they take bigger and bigger gambles, knowing that if the bet goes south, the central bank/state will rush to their rescue.

One of the core sources of resilience is a healthy fear of losses. If you're going to face the consequences of your actions and choices, prudence forces you to either hedge your bets or diversify very broadly, so if bets in one sector go south you won't be wiped out.

Thanks to the permanent manipulation of central banks and states, trillions of dollars have concentrated in high-risk, high-yield carry trades that are now blowing up.

A third source of fragility in manipulated financial systems is the perverse incentives generated by cheap credit and assets bubbles. In markets distorted by permanent manipulation--near-zero interest rates, central bank asset purchases, quantitative easing, etc.--the most powerful incentive is to borrow as much money as you can and leverage it as much as you can to maximize your gains in risk-on asset bubbles.

Why this increases system fragility is obvious: when the bubbles pop, the debt has to be paid back. But once the assets drop enough, selling won't raise enough money to pay back the debt.

At that point, the borrowers are bankrupt, and the dominoes of debt topple the entire financial system.

Dave of X22Report and I discuss these dynamics in Central Banks Have Manipulated The Markets Which Will Ultimately Crash: (42:48)

Thursday, August 27, 2015

If you can't work for yourself and afford health insurance, something is seriously messed up.

By financial independence, I don't mean an inherited trust fund--I mean earning an independent living as a self-employed person. Sure, it's nice if you chose the right parents and inherited a fortune. But even without the inherited fortune, financial independence via self-employment has always been an integral part of the American Dream.

Indeed, it could be argued that financial independence is the American Dream because it gives us the freedom to say Take This Job And Shove It (Johnny Paycheck).

This chart shows the self-employed as a percentage of those with jobs (all nonfarm employees). According to the FRED data base, there are 142 million employed and 9.4 million self-employed. (This does not include the incorporated self-employed, typically physicians, attorneys, engineers, architects etc. who are employees of their own corporations.)

This chart depicts self-employment from 1929 to 2015. Self-employment plummeted after World War II as Big Government and Big Business (Corporate America) expanded and the small family farmer sold to agri-business or went to the city for an easier living as an employee of the government or Big Business.

Self-employment picked up as the bulk of 65 million Baby Boomers entered the work force in the 1970s. Not entirely coincidentally, a 30-year boom began in the 1980s, driven by financialization, technology and the explosion of new households as Baby Boomers got jobs, bought homes, etc. These conditions gave a leg up to self-employment.

Self-employment topped at around 10.5 million in the 1990s, and declined sharply from about 2007 to the present. But the expansion of self-employment from 1970 to 1999 is somewhat deceptive; while self-employment rose 45%, full-time employment almost doubled, from 67 million in 1970 to 121 million in 1999.

Financial independence means making enough income to not just scrape by but carve out a modestly middle-class life. If we set $50,000 as a reasonable minimum for that standard (keeping in mind that households with children recently estimated they needed $200,000 in annual income to get by in San Francisco), we find that according to IRS data, about 7.4 million self-employed people earn $50,000 or more annually.

This works out to a mere 6% of the full-time work force of 121 million, and only 5% of the employed work force of 142 million.

But there are other less structural reasons, such as nonsensically complex and costly regulations--a topic explained here recently by entrepreneur Ray Z. in Our Government, Destroyer of Jobs (August 12, 2015).

As many readers pointed out, these complexity barriers limit competition to Corporate America chains and provide make-work for government employees and politically protected guilds.

What's the difference between a Socialist Paradise where 95% of the people work for the state or a quasi-state institution, and a supposedly "free market economy" in which 95% of the people work for the state or a cartel-state institution? Given that the vast majority of employees are trapped in their jobs by the threat of losing their healthcare insurance, how much freedom of movement and non-inherited financial independence is available?

True financial independence is probably even scarcer than these bleak numbers suggest. As a self-employed person myself, I have to pay my own healthcare insurance costs --a staggering $15,300 per year for bare-bones coverage for the two of us (no meds, eyewear, dental, $50 co-pay for everything, etc.).

Only 3.9 million taxpayers took the self-employed health insurance deduction.That's a pretty good indicator of how many taxpayers are actually living solely on their income, that is, they don't have a spouse who has family healthcare coverage via a government or corporate job.

That's a mere 2.7% of all 142 million employees. If you can't work for yourself and afford health insurance, something is seriously messed up.

Anyone betting China's GDP is really expanding at 7% and the U.S. economy will grow by 3.7% next quarter is angling to be a bagholder.

Once global assets roll over for good, it's important to recall that somebody owns these assets all the way down. These owners are called bagholders, as in "left holding the bag."

Those running the rigged casino have to select the bagholders in advance, lest some fat-cat cronies inadvertently get stuck with losses.

In China, authorities picked who would be holding the bag when Chinese stocks cratered 40%: yup, the poor banana vendors, retirees, housewives and other newly minted punters who borrowed on margin to play the rigged casino.

Corrupt Chinese officials, oil oligarchs and everyone else who overpaid for flats in London, Manhattan, Vancouver, Sydney, etc. will be left holding the bag when to-the-moon prices fall to Earth.

(If nobody buys it at this inflated price, Neil may end up being the bagholder.)

Bond funds that bought dicey emerging market debt (Mongolian bonds, anyone?) and didn't sell at the top are bagholders.

Everyone with bonds and stocks in the oil patch who didn't sell last summer is a bagholder.

Everyone holding yuan is a bagholder.

Everyone who bought euro-denominated assets when the euro was 1.40 is a bagholder at euro 1.12.

Everyone with 401K emerging market equities mutual funds who didn't sell last summer is a bagholder.

Everyone who reckons "buy and hold" will be the winning strategy going forward will be a bagholder.

Anyone buying anything with borrowed money is a bagholder. Leveraging up to buy risk-on assets like Mongolian bonds and homes in Vancouver is brilliant in bubbles, but not so brilliant when risk-on turns to risk-off. As the asset's value drops below the amount borrowed to buy it, the owner becomes a bagholder.

Anyone betting China's GDP is really expanding at 7% and the U.S. economy will grow by 3.7% next quarter is angling to be a bagholder.

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Tuesday, August 25, 2015

Take your pick--here's three good reasons to engineer a "crash" that benefits the few at the expense of the many.

There is an almost touching faith that markets are rigged when they loft higher, but unrigged when they crash. Who's to say this crash isn't rigged? A few things about this "crash" (11% decline from all time highs now qualifies as a "crash") don't pass the sniff test.

Exhibit 1: VIX volatility Index soars to "the world is ending" levels when the S&P 500 drops a relatively modest 11%. The VIX above 50 is historically associated with declines of 20% or more--double the current drop.

When the VIX spiked above 50 in 2008, the market ended up down 57%. Now that's a crash.

Exhibit 2: The VIX soared and the market cratered at the end of options expiration week (OEX), maximizing pain for the majority of punters. Generally speaking, OEX weeks are up. The exceptions are out of the blue lightning bolts such as the collapse of a major investment bank.

Was a modest devaluation in China's yuan really that unexpected, given the yuan's peg to the U.S. dollar which has risen 20% in the past year? Sorry, that doesn't pass the sniff test.

Exhibit 3: When the VIX spiked above 30 in October 2014, signaling panic, the Federal Reserve unleashed the Bullard Put, i.e. the Fed's willingness to unleash stimulus in the form of QE 4. Markets reversed sharply and the VIX collapsed.

Now the VIX tops 50 and the Federal Reserve issues an absurd statement that it doesn't respond to equity markets. Well then what was the Bullard Put in October, 2014? Mere coincidence? Sorry, that doesn't pass the sniff test.

Why would "somebody" engineer a mini-crash and send volatility to "the world is ending" levels? There are a couple of possibilities.

1. The Shock Doctrine. Naomi Klein's landmark study of how manufactured crises are used to justify further consolidation of power, The Shock Doctrine: The Rise of Disaster Capitalism, provides a blueprint for how financial crises set the stage for policies that extend the power of central and private banks and various state-private sector players.

A soaring VIX and sudden crash certainly softens up the system for the next policy squeeze.

2. A "crash" engineered to set up a buying opportunity for insiders. When easy gains get scarce, what better way to skim a quick 10% than engineer a "crash," scoop up shares dumped by panicked punters and momo-following HFT bots spooked by "the world is ending" VIX spike, and then reverse the "crash" with another round of happy talk?

3. Settling conflicts within the Deep State. I have covered the Deep State for years, in a variety of contexts--for example:

Without going into details that deserve a separate essay, we can speculate that key power centers with the Deep State have profoundly different views about Imperial priorities.

One nexus of power engineers a trumped-up financial crisis (i.e. a convenient "crash") to force the hand of opposing power centers. As I have speculated here before, the rising U.S. dollar is anathema to Wall Street and its apparatchiks, while a rising USD is the cat's meow to those with a longer and more strategic view of dollar hegemony.

Take your pick--here's three good reasons to engineer a "crash" that benefits the few at the expense of the many.

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